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THE CHINA AND EURASIA FORUM QUARTERLY Central Asia-Caucasus Institute & Silk Road Studies Program

Volume 6, No. 1 February 2008

The China and Eurasia Forum Quarterly is a publication of the Central Asia-Caucasus Institute & Silk Road Studies Program, edited in Sweden at the Stockholm-based Institute for Security and Development Policy.

The Central Asia-Caucasus Institute & Silk Road Studies Program is a joint transatlantic independent and externally funded research and policy center. The Joint Center has offices in Washington and Stockholm, and is affiliated with the Paul H. Nitze School of Advanced International Studies of Johns Hopkins University and the Institute for Security and Development Policy (ISDP). It is the first Institution of its kind in Europe and North America, and is today firmly established as a leading center for research and policy worldwide, serving a large and diverse community of analysts, scholars, policy-watchers, business leaders and journalists. The Joint Center aims to be at the forefront of research on issues of conflict, security and development in the region; and to function as a focal point for academic, policy, and public discussion of the region through its applied research, its publications, teaching, research cooperation, public lectures and seminars.

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Printed in Singapore by Stallion Press Ltd. © Central Asia-Caucasus Institute & Silk Road Studies Program, 2007. The China and Eurasia Forum Quarterly (ISSN 1653-4212) is published by the Central Asia-Caucasus Institute & Silk Road Studies Program . Map used in the cover design is courtesy of the University of Texas Libraries, The University of Texas at Austin.

THE CHINA AND EURASIA FORUM

QUARTERLY

Volume 6, No. 1 February 2008

Editor-in-Chief

Niklas Swanström Institute for Security and Development Policy, Sweden

This publication was made possible with the support of

The Swedish Ministry for Foreign Affairs

and

The Swedish Research Council

THE CHINA AND EURASIA FORUM QUARTERLY EDITORIAL BOARD

Editor-in-Chief

Niklas Swanström Institute for Security and Development Policy, Sweden

E-mail: [email protected]

Assistant Editors Christopher Len

Institute for Security and Development Policy, Sweden E-mail: [email protected]

Nicklas Norling Institute for Security and Development Policy, Sweden

E-mail: [email protected]

Senior Advisors

Daniel L. Burghart National Defense University,

United States

Svante Cornell Director, Institute for Security and

Development Policy, Sweden

David M. Finkelstein The CNA Corporation, United States

Pan Guang Shanghai Academy of Social Sciences,

China

Bates Gill Center for Strategic and International

Studies, United States

Zhao Huasheng Fudan University, China

James A. Millward Georgetown University, United States

Malia K. Du Mont Co-Founder of the China-Eurasia Forum and Former Associate Editor of the CEF

Quarterly, United States.

Matthew Oresman Co-Founder of the China-Eurasia Forum,

Former Director of the China-Eurasia Forum and Former Editor of the CEF

Quarterly, United States

S. Frederick Starr Chairman of the Central Asia-Caucasus

Institute, United States

Farkhod Tolipov National University of Uzbekistan,

Uzbekistan

Dmitri V. Trenin Carnegie Endowment for International

Peace, Russia

THE CHINA AND EURASIA FORUM QUARTERLY Volume 6, No. 1 February 2008

Contents

Durability in China’s Strategy toward Central Asia – Reasons for Optimism Robert Sutter…..……………………………………………………………………………… 3

How Financial Alchemy Engineered a Central Asian Credit Crunch Maria Kielmas….……………………………………………………………………………….. 11

The Shanghai Cooperation Organization: A Threat to American Interests in Central Asia? Gene Germanovich………………………………………………………………………………19

China’s Investments in Russia: Where do they go and how Important are they? Libor Krkoska and Yevgenia Korniyenko…………………………………………………39

Pashtunistan, NATO and the Global War on Terror: “If you don’t fight, you cannot have peace in Afghanistan” Michael Mihalka………………………………………………………………………………..51

Kazakh-Chinese Energy Relations: Economic Pragmatism or Political Cooperation? Zhanibek Saurbek……………………………………………………………………………….79

Big Business and High-level Politics in Kazakhstan: An Everlasting Symbiosis? Heidi Kjærnet, Dosym Satpaev and Stina Torjesen ………………………………….95

Editor’s Note

Dear Colleagues and Friends, The Olympic Games in August is approaching and the Chinese have been preoccupied with stabilizing internal opposition and fending off international threats of boycotts. Notwithstanding the domestic and international protests and violence surrounding the situation in Tibet, Xinjiang and Central Asia have been relatively quiet. China has arrested a few persons allegedly planning terrorist attacks but most attention has been devoted to Tibet rather than Xinjiang. Many efforts are being put into monitoring and securing the border area between China and Central Asia in Xinjiang, however, to make sure that the situation does not get out of hand in the run-up to the Olympics and during the games.

It is interesting to note that Xinjiang is increasingly becoming a region of potential rather than a region of problems for Beijing. Much of China’s attention now seems to be centered on the positive and integrative effects that the trade between Central Asia and China (Xinjiang) has. For example, China has begun to build a new pipeline between Xinjiang to Hong Kong and Shanghai which, in turn, is part of the Chinese US$2.2billion investment to build a gas pipeline from Turkmenistan to Xinjiang. Rather than showing any indications of retreating from the region, China has increased its investments and interest. To mention one example, it was recently announced that Datong Corporation will initiate the construction of several power stations in Kazakhstan to a value of US$860 million.

There is not only a persistent Chinese interest in the region. India’s first military outpost is nearing completion in Tajikistan; some 150 staff have already been stationed at the new Ayni airbase. This development may indeed be a nuisance for China but it most directly impacts the regional strategic considerations for Pakistan. Added to this is the incremental rapprochement that could be observed in the past few months between Uzbekistan and the US, after their relations unraveled three years ago. The Russian and Chinese roles in Central Asia are challenged, even if Russia still is the single most important actor. The small incursions into Central Asia seen from other actors have nevertheless made the “old” actors in the region concerned. The formation of a Persian-speaking union between Tajikistan, Afghanistan, and Iran together with Turkmenistan’s recent tendencies toward a “multi-vector” foreign policy, including engagement with Azerbaijan and the West, are two recent examples of this.

One factor which consistently works in favor of China and Russia is nevertheless the political development (or non-development) in the region and the reactions from the West. Elections in both Uzbekistan and Kyrgyzstan have been held – and criticized by the West. Karimov was recently re-elected with 88 percent in Uzbekistan, and Igor Chudinov was elected as the new prime minister of Kyrgyzstan. Both elections have been subject to criticism, particularly the parliamentary elections in Kyrgyzstan which were beset by widespread irregularities and failed to meet international standards. Despite this, there seems to be comparatively little criticisms to both elections at this moment in time. Neither China nor Russia has any difficulty accepting a continuation of the status quo while both the EU and the US are displaying a more cautious approach after realizing the side-effects of unrestrained regime criticism. It is unlikely that the US, and particularly the EU, will radically alter their concerns for democracy in the region, but it is likely that they also are starting to realize the costs of non-influence. The trade-off between engaging with the authoritarian leaderships in the region and an uncompromising defense of democratic principles continues to be a difficult one for the West. Kazakhstan’s positive development toward a viable market economy, gradual implementation of democratic reforms, and engagement with the West nonetheless points to the importance of having a nuanced and patient approach toward these countries.

The authors in this issue will focus on China’s engagement with Kazakhstan, Russia, and Central Asia in general, with a particular focus on Kazakhstan’s financial development. While it is clear that Kazakhstan is rapidly improving its investment climate and has set an example for the other Central Asian states to follow, it is also clear that the Kazakh financial system exhibits vulnerabilities. US-SCO relations will also be explored in-depth while the current fragility of NATO is also examined. On behalf of the CEF team, we hope you will enjoy your read.

Niklas Swanström Editor China and Eurasia Forum Quarterly [email protected]

China and Eurasia Forum Quarterly, Volume 6, No. 1 (2008) p. 3-10 © Central Asia-Caucasus Institute & Silk Road Studies Program ISSN: 1653-4212

Durability in China’s Strategy toward Central Asia – Reasons for Optimism

Robert Sutter*

Debate continues among specialists of Chinese foreign relations as to whether or not Chinese foreign policy and behavior in the post-Cold War period reflect a coherent strategy that is likely to continue, or reflect sometimes contradictory goals and circumstances that could change and in turn change the direction of Chinese foreign policy and behavior. This assessment shows that contradictions and intruding circumstances that could change Chinese foreign policy and behavior seem less salient in China’s approach to Central Asia than in other areas of Chinese foreign relations. As a result, it argues that continuity in China’s strategy toward the region seems likely for some time to come.

Debate over China’s Strategy in Foreign Affairs

An outpouring of books, articles and other assessments and analyses by scholars and specialists document ever expanding Chinese interaction with the outside world through economic exchanges in an era of globalization, and broadening Chinese involvement with international organizations dealing with security, economic, political, cultural and other matters. They demonstrate a continuing trend toward greater transparency in Chinese foreign policy decision making and policy formation.1

* Robert Sutter is Visiting Professor of Asian Studies, School of Foreign Service, Georgetown University, Washington DC. E-mail: [email protected] 1 David Michael Lampton, Ed., The Making of Chinese Foreign and Security Policy in the Era of Reform (Stanford: Stanford University Press, 2001); Bates Gill, Rising Star: China’s New Security Diplomacy (Washington: Brookings Institution, 2007); Yong Deng and Fei-Ling Wang, Eds., China Rising: Power and Motivation in Chinese Foreign Policy (Lanham, Md.: Rowman and Littlefield, 2005); David Shambaugh, Ed., Power Shift: China and Asia’s New Dynamics (Berkeley: University of California Press, 2005); Evan Medeiros and R. Taylor Fravel, “China’s New Diplomacy,” Foreign Affairs 82, 6 (November-December 2003), pp. 22-35; Alastair Iain Johnston and Robert S. Ross, Eds., New Directions in the Study of China’s Foreign Policy (Stanford: Stanford University Press, 2006); Phillip C. Saunders, China’s Global Activism: Strategy, Drivers, and Tools (Washington: National Defense University Institute for National Strategic Studies Occasional Paper 4, June 2006); Zheng Bijian, “China’s ‘Peaceful Rise’ to Great-Power Status,” Foreign Affairs 84, 5 (2005), pp. 18-24.

Robert Sutter

THE CHINA AND EURASIA FORUM QUARTERLY • Volume 6, No. 1

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In general, Chinese leaders are seen to be focused on promoting

China’s economic development while maintaining political and social stability in China. These efforts undergird a fundamental determination of the Chinese Communist Party (CCP) administration to reinvigorate and sustain its one-party rule in China. Foreign policy is made to serve these objectives by sustaining an international environment that supports economic growth and stability in China. This is done partly through active and generally moderate Chinese diplomacy designed to reassure neighboring countries and other concerned powers, notably the United States, the dominant world power in Chinese foreign policy calculations. Chinese efforts try to demonstrate that rising Chinese economic, military and political power and influence should not be viewed as a threat, but should be seen as an opportunity for greater world development and harmony. In the process, Chinese diplomacy gives ever greater emphasis to engagement and conformity with the norms of regional and other multilateral organizations as a means to reassure those concerned with possible negative implications of China’s increased power and influence.

Chinese foreign policy places great emphasis on seeking international economic exchange beneficial to Chinese development. China has become the center of a variety of intra-Asian and other international manufacturing and trading networks that have seen China emerge as the world’s third largest trading nation and a large or the largest consumer of a variety of key world commodities and raw materials, notably oil. China today depends fundamentally on a healthy world economy in which Chinese entrepreneurs promote economic development as an essential foundation for continued rule of the CCP administration. At the same time, the world economy depends increasingly on China. China is a key manufacturing center for world markets and an increasingly prominent trading nation with a positive balance of trade and the largest foreign exchange reserves in the world.

Chinese nationalism and Chinese security priorities also are important determinants in contemporary Chinese foreign policy. The CCP administration has placed greater emphasis on promoting nationalism among Chinese people as communism has weakened as a source of ideological unity and legitimacy. Nationalism supports the CCP administration’s high priority to prevent Taiwan independence and protect Chinese territorial claims.2 Chinese leaders build advanced

People’s Republic of China State Council Information Office, “China’s Peaceful Development Road,” People’s Daily Online, December 22 2005. Yan Xuetong, “The Rise of China and its Power Status,” Chinese Journal of International Politics 1 (2006), pp. 5-33. 2 Suisheng Zhao, A Nation-State by Construction: Dynamics of Modern Chinese Nationalism (Stanford: Stanford University Press, 2004); Peter Gries, China’s New Nationalism (Berkeley: University of California Press, 2004).

Durability in China’s Strategy Toward Central Asia – Reasons for Optimism

THE CHINA AND EURASIA FORUM QUARTERLY • February 2008

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military power and voice determination to take coercive measures to achieve nationalistic goals.3 More broadly, Chinese leaders seek to build what they call “comprehensive national power”—particularly economic, military, and political power—as China seeks an as yet not clearly defined leading role as a great power in Asian and world affairs.

Issues in the Debate

Despite considerable agreement among specialists about the course and many of the goals in Chinese foreign policy after the cold war, there also is considerable uncertainty and debate over the durability of China’s recent approach. Some specialists judge that China’s leaders are following a firm strategy that will last well into the 21st century. Others argue that China’s approach is subject to change, particularly as major uncertainties and variables could push Chinese foreign policy in directions different than the recent course.

On one side, Chinese government officials and some Chinese and foreign scholars and specialists emphasize that the mix of Chinese government priorities and prevailing conditions in the post-cold war provide the basis of a Chinese strategy of peace and development that will last for decades.4 The Chinese leadership is seen as determined to avoid confrontation in Chinese foreign policy as it pursues economic development at home and abroad in the interest of enhancing the legitimacy and standing of the CCP administration. China’s cooperative diplomacy and international activism will grow as China seeks the role of a responsible world power endeavoring to preserve and enhance China’s international rights and privileges while it pulls its weight with greater international contributions, commitments, and obligations. Chinese leadership priorities regarding economic development and domestic stability also favor a foreign policy that is inclined to accept the world situation as it is and avoid the often disruptive and assertive Chinese initiatives in world affairs during the Maoist period. Thus, China’s strategy is said to accept the prevailing international and regional balance of power and influence that is often dominated by the United States. It pursues China’s advantage by working with existing regional and other international economic organizations, and by cooperating more closely with international groupings dealing with security, politics, culture, the environment, and other matters.

On the other hand, arguments against a durable strategy in post-Cold War Chinese foreign relations focus on several factors:

3 David Shambaugh, Modernizing China’s Military (Berkeley: University of California Press, 2002); Dennis Blasko, The Chinese Army Today (London: Routledge, 2006). 4 These assessments are reviewed in Robert Sutter, Chinese Foreign Relations: Power and Policy Since the Cold War (Lanham, Md.: Rowman and Littlefield, 2007), pp. 3-7.

Robert Sutter


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• Chinese goals of peace and development in foreign affairs seem

contradicted by strong Chinese goals emphasizing nationalistic interests and claims and the determination of the Chinese administration to protect Chinese security and other interests at home and abroad by using military force if necessary. In the area of Chinese national security, Thomas Christensen argued that while the priorities of the Chinese leadership seemed clear, “many of the means to reach the regime’s domestic and international security goals are so fraught with complexity, and sometimes contradiction, that a single, integrated grand plan is almost certainly lacking, even in the innermost circles of the Chinese leadership compound.”5

• Chinese foreign policies and behavior remain heavily influenced by the policies and behavior of external forces that the Chinese administration does not control. Notable examples are the United States, Japan, and the Taiwan leadership. Susan Shirk demonstrated that significant shifts in the policies and behavior of these actors could prompt shifts in China’s overall foreign policy approach.6

• The ability of the Chinese leadership to forge and sustain a coherent strategy in foreign affairs is weakened by the leadership’s continuing lack of confidence and uncertainty about the legitimacy of the Communist Party administration at home and its relative power and influence abroad. While some observers in China and abroad highlight growing Chinese confidence and assurance in world affairs, a wide range of Chinese and foreign specialists underline continued leadership uncertainties caused by concerns over the leadership’s domestic legitimacy and its weak international standing relative to the United States in particular.7

Why Chinese Strategy in Central Asia is Durable

The end of the Cold War, the collapse of the USSR, and improvement in Russia-China relations defined Chinese policy and behavior toward Central Asia. Post-Cold War developments on the one hand resulted in the creation of new states, reduced Moscow’s influence, and opened avenues for spreading Chinese interests. On the other hand, the collapse

5 Thomas Christensen, “China,” in Strategic Asia, 2001-2002, Eds. Richard Ellings and Aaron Friedberg (Seattle: National Bureau of Asian Research, 2001), p. 27. 6 Susan Shirk, China: Fragile Superpower (New York: Oxford University Press, 2007) pp. 140-254. 7 Shirk, China: Fragile Superpower, pp. 6-9; See review in Sutter, Chinese Foreign Relations, pp. 8-10.



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of the USSR also created a power vacuum that posed problems for Chinese security.8

Generally preoccupied with affairs at home and seeking to stabilize China’s periphery, Chinese officials worked to secure boundaries and advance relations with newly independent Central Asian states, as much for defensive reasons as for reasons of expanding Chinese influence and interests. For over a decade, China’s more active interaction with the former Soviet republics in Central Asia, notably through regional groups such as the Shanghai Five, and its successor, the Shanghai Cooperation Organization (SCO) begun in 2001, avoided serious challenge to Russian interests in the region and endeavored to strengthen cooperation among China, Russia and Central Asian states in ways that tried to exclude the United States and curb Western influence.9

The U.S.-led global war on terrorism and the toppling of the Taliban regime in Afghanistan in 2001 had a major effect on China’s relative influence in Central Asia. The stronger U.S. military presence and strategic influence in Central Asia meant that China’s relative influence would remain secondary to the United States and Russia. Chinese leaders adjusted pragmatically to the new situation. They continued to pursue previous incremental efforts to improve relations with the Central Asian governments. Effective China’s diplomacy in bilateral relations and multilateral forums like the SCO, growing trade relations, and increasing Chinese interest in Central Asian oil and gas laid the foundations for growing Chinese prominence in Central Asia.10

While Chinese leaders have had several important interests and goals in pursing relations with Central Asia, they have managed them without significant conflict, reinforcing the likelihood of continuity and durability in China’s approach to the region. Notably in contrast to Chinese approaches in eastern and southern Asia, there has been less tension between China’s national development emphasis on promoting peace and development abroad and Chinese national security, territorial, and national unification objectives that emphasize China’s use of force against foreign threats in ways that alienated and alarmed some of China’s neighbors and other concerned powers.

8 Matthew Oresman, “Repaving the Silk Road: China’s Emergence in Central Asia,” in China and the Developing World Eds. Joshua Eisenman, Eric Heginbotham, and Derek Mitchell (Armonk NY: M.E. Sharpe 2007), pp. 60-83. 9 Gill, Rising Star: China’s New Security Diplomacy, pp. 37-52. 10 Niklas Swanstrom, “China and Central Asia: A New Great Game or Traditional Vassal,” Journal of Contemporary China 14, 45 (November 2005), pp. 569-584; Kevin Sheives, “China Turns West: Beijing’s Contemporary Strategy Toward Central Asia,” Pacific Affairs 79, 2 (Summer, 2006), pp. 205-224.

Robert Sutter


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The varied Chinese interests and goals11 have involved:

• Borders and Security: China’s sought to demarcate, demilitarize and stabilize borders with Russia, Kazakhstan, Kyrgyzstan, and Tajikistan. Border stability has been central to Chinese development plans and foreign policy priorities. China also has sought to curb outside support to separatists in Xinjiang province. It sees common ground with regional governments in working against terrorist and criminal elements.

• Economic: China’s main economic interest in the region is energy—China has sought growing amounts of oil and gas abroad and Central Asia—especially Kazakhstan--appeared as a promising partner.

• Regional Position: China’s engagement with Central Asia, and specifically the SCO, is part of China’s overall effort to foster a stable and productive international environment around China’s periphery while fostering a more widely accepted Chinese leadership role. Beijing’s relations with Central Asia also aim to legitimate Chinese positions on major international issues, strengthen relations with Russia, and serve as a counter to U.S. power and influence. China’s diplomacy in Central Asia aims to prevent the region from becoming a distraction from China’s internal development and more important foreign policy goals. One of the reasons China’s administration has been able to develop

and sustain a coherent approach in post-Cold War Central Asia despite potentially conflicting goals is that external forces that the Chinese administration does not control and that strongly influence Chinese foreign policy in other areas do not play much of role in China-Central Asian relations. For example, Taiwan is insignificant in Central Asia. Chinese threats to use force against Taiwan separatism have much less disruptive impact on China’s Central Asian neighbors than they do elsewhere around China’s periphery. Japan’s role in Central Asia also is relatively small. China’s sometimes strident reactions to disputes with Japan have less disruptive impact on China’s relations with Central Asia neighbors than on Chinese relations with neighbors in other parts of China’s periphery.

The upswing in U.S. military presence and influence in Central Asia after the terrorist attack on America was an important change in China’s strategic calculus in Central Asia. However, its overall impact has been off-set by the fact that the foundation of U.S. power in Central Asia is much weaker than in other parts of China’s periphery.12 Also, the record

11 Oresman, Repaving the Silk Road, pp. 62-72. 12 Michael Mihalka, “Not Much of a Game: Security Dynamics in Central Asia,” China and Eurasia Quarterly 5, 2 (2007), pp. 21-39.



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of relatively low levels of follow-on U.S. aid and official involvement in the region, and Russia’s continued leading importance among the Central Asian republics also has diminished Chinese concerns about the U.S. military presence and influence in Central Asia.13

Meanwhile, changes in Chinese foreign policy and behavior influenced by Chinese leaders’ lack of confidence and uncertainty in their legitimacy at home and abroad are less in the case of Central Asia than in other parts of China’s periphery.14 Notably, the need for Chinese leaders to adopt tough policies on territorial or other nationalistic issues with Central Asian neighbors is less than in the case of Chinese relations with some neighbors to China’s east and south. Part of the reason is that the Chinese administration has been successful in keeping Chinese media and other public attention focused away from territorial and nationalistic issues with Central Asian neighbors. Also, Chinese territorial and nationalistic issues with Central Asian neighbors seem less salient to core Chinese interests in development and national power than Chinese territorial and nationalistic issues with some other neighbors. And, the generally authoritarian Central Asian governments have endeavored to deal constructively and pragmatically with China over territorial and other disputes, a contrast with the nationalistic posturing of some of China’s eastern and southern neighbors.

Sources of Uncertainty

Though the course of China’s strategy toward Central Asia seems more stable than in other areas of Chinese foreign relations, there remain significant uncertainties clouding the longer term outlook. For one thing, specialists are divided on China’s long term goals in the region and how these goals could lead to a major change in China’s approach to the region. Some emphasize strongly that the prevailing Chinese interest in regional stability and energy trade will remain core determinants of Chinese policy and will reinforce continuity in the Chinese policy and behavior we see today.15 However, others argue that recent accommodating and moderate Chinese policies and behavior presage the creation of an emerging Central Asian order dominated by China that will be reminiscent of the Sino-Central Asian relationship during the strong dynasties in Chinese history.16

Meanwhile, China’s influence in Central Asia and developments in the region depend heavily on the power and policies of Russia. Russian

13 Dan Burghart, “The New Nomads? The American Military Presence in Central Asia,” China and Eurasia Forum Quarterly 5, 2 (2007), pp. 5-19. 14 Compare Shirk, China: Fragile Superpower, pp. 140-254 with Oresman, Repaving the Silk Road, pp. 75-80. 15 Sheives, “China Turns West.” 16 Swanstrom, “China and Central Asia.”

Robert Sutter


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weakness in the 1990s provided the opportunity for expanding Chinese influence in Central Asia and the foundation of Russian inclination to cooperate closely with rising China on trade, including arms trade, and a variety of international issues. Under the leadership of Vladimir Putin, Russia has endeavored to rebuild elements of national strength and to use them to reassert Russian interests against those perceived as encroaching on Russian interests. Thus far, the Russian relationship with China generally has remained cordial and cooperative, though Russia-China competition for influence in Central Asia and over other issues continues.17 If China were to be seen to seek regional dominance in Central Asia, Russia might adopt more competitive and perhaps confrontational policies that would have a major impact on China’s existing approach to the region. At the same time, if Russia successfully pursues a more assertive leadership role in the region, China’s leaders presumably would be forced to choose between accommodating rising Russian power and possibly losing Chinese equities and influence, or resisting the Russian advances.

17 Celeste Wallander, “Russia: The Domestic Sources of a Less-than-Grand Strategy,” in Strategic Asia 2007-2008 Eds. Ashley Tellis and Michael Wills (Seattle: National Bureau of Asian Research 2007), pp. 138-175.


How Financial Alchemy Engineered a Central Asian Credit Crunch

Maria Kielmas*

Introduction

Kazakhstan became the darling of the international markets over the decade that followed the Russian and Asian financial crises of 1997-98. Energy companies continued to invest in the country’s oil and gas industries despite the Kazakh government’s tightening control on the sector, and the formidable technical problems associated with the production of oil and gas in this region. Kazakh banks acquired an appetite for foreign borrowing, mostly to finance the domestic construction industry, itself booming as the population at last grasped the new opportunities of mortgages and home ownership. International hedge funds, dubbed variously over this decade as the guerrillas of the investment world, the saviors of pension funds, and the financial markets’ very own philosopher’s stone, targeted Kazakhstan and its banking sector as the “emerging market” par excellence.

It all began to unravel in mid-2007 as the effects of the U.S. sub prime mortgage crisis began to reverberate around the world. However, it was only in February 2008 when three announcements brought home the truth.

• On February 1, the credit rating agency Standard & Poor’s

announced that it had changed its ratings on 44 emerging market asset-backed securities (ABS) future flow securitizations two of which, JSC Bank TuranAlem and Kazkommerts DPR, were issued by Kazakh banks. The reason for the S&P downgrade was that the agency had placed the ratings of two of the financial guarantors of these issues, New York-based MBIA Insurance Corp (MBIA) and Bermuda-based XL Capital, on negative watch.

• On February 19 the London-based European Bank for Reconstruction and Development (EBRD) announced that it plans to earmark up to half a billion dollars in much-needed funding for Kazakh banks as they struggle to borrow

* Maria Kielmas is a London based journalist and energy consultant.

Maria Kielmas


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internationally. Kazakh banks have borrowed more than US$45 billion overseas. This is equivalent to 95 percent of the country’s GDP, is larger than Russia’s foreign debt of US$44 billion, and of Kazakhstan’s total foreign reserves, including its oil fund, of US$40 billion.

• On February 27, the government of Kazakhstan announced that it would impose export tariffs on wheat and triggered a 25 percent overnight rise in international wheat prices in the process. The immediate cause of the tariff imposition was the rise in wheat and bread prices domestically; a consequence of extreme weather conditions and low stocks, which already had fuelled public protests.

So it must have come as a measure of relief, albeit to a specialist

audience, when the following day a London-based financial publisher awarded Bank TuranAlem an award for “Best Deal 2007” for its innovative financing of a cement plant in Akmola Oblast. In the context of today’s worldwide credit crunch, cynics may view such awards as the triumph of hope over experience. The financial sector always seems to innovate its way out of a credit crisis.

We have been here before

It is as if the collapse of Long Term Capital Management (LTCM) and Enron never happened. Ten years after the demise of a hedge fund – run by no less than three winners of the Nobel Prize in Economics – which gave rise to the term “financial engineering”, and seven years after the fall of its energy industry analogue, Enron, governments, regulators, financiers and sundry analysts are struggling to explain why we are in the midst of yet another financial crisis. How does the inability of “Joe Six-pack” in a U.S. Midwest small town to pay his mortgage have such an impact in Central Asia? In late January, an apt explanation came forward in the credit downgrading, possible collapse, and probable rescue of bond insurers.

Until recently the names Ambac Assurance Corp., MBIA Insurance Corp., ACA Capital Holdings, Financial Guarantee and Insurance Corporation (FGIC), and XL Capital were unknown outside of a much-specialized financial market. These companies insure the bonds issued by private companies, state-owned enterprises and municipalities. Known as “monolines” these insurers (except for XL Capital which is a Bermuda-based reinsurer) started in business by covering bonds issued by (mostly) U.S. municipalities where the default rate was less than 1 percent. For a modest fee, the financial guarantee provided by the insurers upgrades a bond’s credit rating to investment grade. This depends on the insurers



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themselves being graded “AAA” (or Triple “A”) by agencies such as Fitch, Moody’s and Standard & Poor’s. It was a low margin, low credit risk business which did not require a massive amount of capital. Matters changed in the 1990s when structured financial instruments became widespread and the bond insurers extended their services to, among others, the energy industries and developing economies known as “emerging markets”. By comparison, the Lloyds of London insurance market has been forbidden by law since the 1930s to issue financial guarantees.

Structured finance in the form of bonds backed by mortgages has been around since the 19th century. However, it took the liberalization and deregulation of the financial markets in the 1990s and the repeal of the 1933 Glass-Steagall Act by the Clinton administration in 1999 to trigger a boom. Under the Act, U.S. banks were not allowed to use depositors' money in anything other than loans. After its repeal, banks, insurance companies and other financial institutions could compete against each other as they pleased. Regulatory control was kept to a minimum, due largely to strong lobbying by Wall Street and its supporters in Congress, especially for complex derivative instruments such as today’s ill fated collateralized debt obligations (CDOs). In Europe, there never was an equivalent of the Glass-Steagall Act. As a result, financial institutions in France and Scandinavia bankrupted themselves in ill-advised mergers and shopping sprees in the 1980s and early 1990s.

In the new deregulated climate, banks were able to offload their loans to insurance companies, pension funds and the like rather than as in the past, keeping them on their books and holding adequate reserves. The loans were repackaged with a variety of swaps and credit-linked notes into the complex financial instrument known as the CDOs, insured by the monocline insurers, and sold as a top-notch investment security to the rest of the financial world. The entire process is called collectively “securitization”. Even the mathematics doctorates who invented these instruments had no idea of how to track the real exposure in CDOs. That is, they had and still have little real idea of how much capital is at risk. So to cover this, they invented approximate models that, like many of the mathematical models that claim to depict climate change, fall apart at the first hint of reality. Frank Partnoy, Professor of Law at San Diego University observed that the sellers could pass off these complex derivatives to buyers who did not understand them.1 The buyers, for their part, could use the CDOs to minimize their own capital requirements or

1 Frank Partnoy writing in the "Conglomerate Blog: Business Law, Economics & Society," Conglomerate, November 12 2007. (March 1 2008)

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boost their yields. Credit rating agencies are paid fees by the monoline insurers and the CDO issuers to monitor the securities and, in effect, act not as purveyors of accurate information, but of “regulatory licenses that unlock financial doors for regulated investors”, Partnoy says.2 William Ackman, head of New York-based hedge fund Pershing Square Capital Management, noted that there was a huge conflict of interest all along the line. MBIA and Ambac reinsure, i.e. offload their insurance, to each other as well as their Bermuda-based captive reinsurers. The credit ratings of these reinsurers are not updated regularly and so offer the potential for abuse, said Ackman in a letter to the three main agencies.3 The credit rating agencies were similarly admonished in 2001 for their lack of reporting on Enron’s shortcomings.

Expansion into Eurasia

Up until autumn 2007 when the credit crisis caught up with the bond insurers these were making great strides into emerging markets in particular in major oil-producing countries such as Kazakhstan and Mexico. Kazakhstan’s first ever mortgage-backed securitization was managed by Dutch Bank ABN AMRO and offloaded US$150 million of mortgages held by BTA Ipoteka, the mortgage subsidiary of Bank TuranAlem. Subsequent mortgage securitizations by BTA Ipoteka were guaranteed in part by agencies such as the World Bank’s Multilateral Investment Guarantee Agency (MIGA). Without the financial guarantees provided by such insurers, state oil enterprises and numerous national banks would have been unable to obtain investment grade credit for their paper. So the costs of credit, used for example for capital investment by state-owned oil companies, would have been substantially higher and an excessive financial burden on government budgets. One of the most spectacular inventions of financial engineering over the past five years has been the securitization of diversified payments rights (DPRs). These enable banks in non-investment grade countries to harness financial flows such as commodity export revenues for their own funding. This arises from the banks’ positions as intermediaries between the commodity seller and buyer. In April 2007, Kazakhstan was planning to issue up to US$500 million in such bonds. The securities were to be guaranteed by multilaterals such as the Asian Development Bank as well as two bond insurers MBIA and FGIC and reinsurer XL Capital. Kazakhstan became the poster child for such deals, one of which was downgraded less than a year later.

2 Ibid. 3 Letter sent by William Ackman to rating agencies Standard & Poor's, Moody's and Fitch, January 18 2008.



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Every financial crisis needs its saviors and this one is no different. A variety of banks and private investors such as Warren Buffett, CEO of U.S. financial conglomerate Berkshire Hathaway and popularly known as the “”Sage of Omaha”, have been suggested. Buffett has even offered a bail out package to two of the bond insurers. Now sovereign wealth funds (SWF) have been suggested as potential saviors. The first SWF was established in 1953 by Kuwait. Several years of high oil and commodity prices have led to the creation of 12 such funds in the last three years. Kazakhstan’s oil fund holds an estimated US$22 billion. The World Bank and International Monetary Fund (IMF) have been active in persuading commodity-producing countries especially to create funds that could be used to stabilize domestic economies during periods of price volatility, as well as providing a long-term national pension fund. These government investment vehicles are generally regarded as having a high risk tolerance. According to Robert Kimmett, Deputy Secretary at the U.S. Treasury Dept., the SWF assets total about US$2.9 trillion. This compares with an estimated US$190 trillion in global financial assets. Hedge funds by comparison manage US$1.5 trillion while pension funds total US$53 trillion. Mostly opaque in their operations, the most transparent fund is Norway’s. But even this fund does not provide any information about its holdings in derivatives (see Table 1 below).

Table 1. Largest Sovereign Wealth Funds (Assets under Management)

Country Fund name Assets US$bn

Inceptionyear

Source of funds

UAE Abu Dhabi Investment Authority

250 to 875 1976 Oil

Norway Government Pension Fund 300 1996 Oil Saudi Arabia

Saudi Arabian funds (various)

250+ n/a Oil

Kuwait Kuwait Investment Authority

160 to 250 1953 Oil

China China Investment Corp. 200 2007 Non-commodity

Russia Stabilization Fund of Russian Federation

120 2004 Oil

Singapore Government Investment Corp.

100+ 1981 Non-commodity

Singapore Temasek Holdings 100+ 1974 Non-commodity

Australia Australia Future Fund 54 2006 Non-commodity

Qatar Qatar Investment Authority 50 2005 Oil

Algeria Revenue Regulation Fund 40 2000 Oil US (Alaska)

Permanent Fund Corporation

35 1976 Oil

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Brunei Brunei General Reserve Fund

30 1983 Oil

South Korea

Korea Investment Corporation

20 2005 Non-commodity

Malaysia Khazanah Nasional 18 1993 Non-commodity

Kazakhstan Kazakhstan National Fund 18 2000 Oil Canada Alberta Heritage Fund 15 1976 Oil Venezuela National Development

Fund 15 2005 Oil

Iran Oil Stabilization Fund 13 1999 Oil New Zealand

Superannuation Fund 11 2001 Non-commodity

Source: IMF GFSR (September 2007), The Economist, futurefund.gov.au, nzsuperfund.co.nz.

Limits of Sovereign Wealth Funds

But SWFs have their own limits. The creation of such funds is premised on the notion that the years of plenty come first. Unless the fund can borrow against future income, it cannot exercise a stabilizing influence on government budgets. So the fund has an additional political burden of first acting as a drag on the economy before it can be a stimulus. In addition, a series of IMF studies has found that these funds have not always acted as a restraint on government expenditure. The operational objective has been to smooth government revenue while the government’s policy objective has been to smooth government expenditure. Combined with the fact that oil prices do not fluctuate around a constant average, the result is that the funds do not have an automatic savings mechanism. So the fund’s balance is determined entirely by the national budget.

The most high profile investments by SWFs in recent months have been in troubled American banks such as Citigroup, Morgan Stanley and Merrill Lynch. Britain’s Barclay’s Bank invited Singapore’s Investment Corporation and China’s Development Bank to become shareholders. But governments have drawn the line on foreign sovereigns taking controlling stakes in major companies. In the 1980s UK Prime Minister Margaret Thatcher instructed the Kuwait Investment Office’s (KIO) to dispose of its 24 percent stake in BP which had been acquired in the wake of an earlier financial crisis. Similarly, the U.S. Congress halted the China National Oil Corporation’s attempt to buy Unocal in 2005. Troubled bond insurers may hope to follow U.S. banks to receive a capital injection from the SWFs, but these insurers are still expected to lose many billions of dollars over coming years as much of their questionable business unravels. In the meantime, the SWFs themselves may be obliged by their own governments to bail out national financial



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sectors. This has already been the case in Russia as well as Kazakhstan. In the latter case, the oil fund may be expected also to bail out the construction sector and even agriculture if the current bread price crisis continues. Currently Kazakhstan’s oil fund is believed to hold 25 percent of its assets in equities and the remainder in cash deposits and fixed income securities.

Conclusion

“Why should I invest in something I can’t even spell?” This was the Southern sensibility of David Bronner, head of the Alabama state pension fund in 1992 when Wall Street traders tried to sell him some complex derivative deals. Officials from California’s Orange County called Bronner “antiquated” and bragged about their investment returns. Those boy geniuses at Orange County, who eventually gambled away US$1.7 billion of public funds on the new-fangled financial instruments invented by Wall Street’s rocket scientists, were led by the county’s treasurer, 70-year old Robert Citron, who did not have a college degree and had visited New York just four times in his life. Citron used structured derivatives to bet on low interest rates but lost out when the Federal Reserve raised its rates on 4 February 1994. Asked the previous year how he knew that interest rates would not rise, Citron replied, “I am one of the largest investors in America. I know these things.” But when the scale of his losses became known Citron was humble. “I am an inexperienced investor,” he pleaded to a California State Senate Committee.

Frank Partnoy recounts this anecdote in his 2003 book “Infectious Greed” which explained, among other things, how the U.S. energy giant Enron collapsed amidst massive fraud that led to the conviction and imprisonment of various of its business executives and the eventual death of its founder, Ken Lay.4 Enron traders used to boast that the more complex, inexplicable and even fictitious their mathematical models of energy markets were, the easier it was to fool naïve clients, most of whom were too scared to admit they did not understand the product they were buying. Prior to its collapse, U.S. economist and Nobel Prize winner Myron Scholes claimed that Enron’s clever trading model would eventually replaced organized securities exchanges. Scholes at the time was working at hedge fund Long term Capital Management (LTCM) that collapsed in 1998 losing an estimated US$4.8 billion. For anyone who remembers the details of these crises, today’s worldwide credit crunch comes as little surprise. The difference is that today it has gathered up “emerging market” stars such as Kazakhstan in its wake. The last decade

4 Frank Partnoy, Infectious Greed - How Deceit and Risk Corrupted the Financial Markets (London: Profile Books Ltd., 2003).

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of high commodity prices, though coupled with low inflation and as well as economic growth, has boosted a false confidence in oil and commodity producing countries. Domestic companies borrowed highly on the international markets using financial engineering instruments that were poorly understood but in reality were part of a vast vortex of the same money rotating around the world. It was only a matter of time when this vortex would collapse in on itself.

Over the same period, commodity producing countries have followed advice from the World Bank and IMF and created sovereign wealth funds. These were supposed to be a form of national “rainy day” or pension fund. Industrialized country governments have worried that SWFs would adopt a “political” approach to investment and overturn western dominance over the world economy. But the reality is quite the opposite. SWFs not only have been used to bail out western financial institutions on the verge of a bankruptcy due to their own arrogance and ignorance, but also now probably will have to do the same in their own domestic economies. The result is that if SWFs are not already embroiled in today’s financial chaos, they soon will be. Financial engineers all over the world may find more innovative ways of papering over the chaos, but such alchemy is unlikely to affect the high price of bread in Kazakhstan.


The Shanghai Cooperation Organization: A Threat to American Interests in Central

Asia?

Gene Germanovich*

ABSTRACT With the apparently rising, Chinese-led, and Russian-supported Shanghai Cooperation Organization (SCO) attracting increased attention in Washington, a question arises as to the level of danger the bloc poses to U.S. objectives for Central Asia. Is it a threat to U.S. interests in the region or largely irrelevant to those interests? To what extent does the nascent SCO currently pose a challenge, and secondly, what developments should the policy community track to assess the SCO as it relates to U.S. objectives for the region? This article explores contending views regarding this rising organization. Keywords • Shanghai Cooperation Organization • Central Asia• Peace Mission 2007 •U.S.-Central Asia interests

Introduction

In the mid-1990s China, Russia, and several Central Asian countries resolved a series of border disputes, which ultimately led to the formation of a new multilateral security organization known as the “Shanghai Five.” At the time, it appeared as if the China-led initiative was merely another addition to the alphabet soup of newly emerging multilateral groupings around the world. A little more than a decade later, this group – now dubbed the Shanghai Cooperation Organization (SCO) – conducted a large-scale military exercise. The SCO’s “Peace Mission 2007” involved a reported 6,500 troops, 80 aircraft, a war game at the general staff level, troop movements across 10,000 kilometers, and a “spectacular air and ground assault.”1 Open source literature does not, at least as of yet, identify

* The author is a defense consultant at a Washington, D.C.-based firm. The author thanks Jennifer Sims for numerous reviews and discussions. Several anonymous reviewers also provided meaningful guidance. The views in this article do not necessarily reflect anyone’s other than those of the author. 1 As quoted in Jane’s Information Group, “Sino-Russian differences over Central Asia persist,” Foreign Report, August 30 2007. For the most comprehensive analysis of the Peace

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specifics regarding the military objectives of the exercise, but the predominant view describes the event as contingency planning for a scenario in which SCO member states would militarily intervene to assist a Central Asian government in either defeating a terrorist organization or reversing a Color Revolution-style mass uprising. With the United States notably absent from the list of observer nations and Vladimir Putin, Hu Jintao, and their authoritarian colleagues from Central Asia viewing the exercise through a set of binoculars, this message could not be clearer: American influence in the region will diminish as Russia and China regain their rightful status as the dominant powers in Central Asia.

Peace Mission 2007 raises a pressing yet relatively unexamined question: does the SCO present a challenge to U.S. national interests in Central Asia?2 Apprehension consumes American scholars, journalists, and government officials who point to the SCO as a short-term competitor and long-term threat.3 American interests in Afghanistan appear at stake, with the SCO in 2005 taking an unambiguous stance against a U.S. military presence on the territory of its member states. In the longer-term, Russia has hinted that it may attempt to form what would essentially amount to a natural gas cartel with an anti-American economic agenda. The possibility that Iran, which currently enjoys observer status, may attain full membership presents a disturbing thought to American strategists seeking to limit Tehran’s influence in Asia. Even the idea of the SCO as a counterbalance to NATO attracts attention. As Deputy Assistant Secretary of State for South and Central Asia Evan Feigenbaum recently summarized, the SCO is “a subject that seems to make a lot of Americans blood just boil.”4 But do SCO actions and intentions merit the anxiety? Both Beijing and Moscow privately value the U.S.-led mission to cultivate a stable, Taliban-free Afghanistan: the Taliban’s connections to terrorist and separatist groups in the region posed a serious threat to China’s West, Russia’s South, and the entirety of Central Asia. Divergent interests and mutual suspicions amongst the

Mission 2007 exercises, see Marcel de Haas, “The ‘Peace Mission 2007’ Exercises: The Shanghai Cooperation Organization Advances,” Central Asian Series, Advanced Research and Assessment Group at the Defense Academy of the United Kingdom, September 2007. 2 For the purposes of this article, I define Central Asia broadly and include the five Central Asian states and their periphery (Afghanistan, Iran as it relates to non Mid-East issues, China’s western province of Xinjiang, and Russia’s southern regions). The SCO has a limited impact on issues falling outside of this geographic limit (e.g. Taiwan), but most of the scholarly and policy debate surrounds Central Asia. 3 The six SCO members (China, Russia, Kazakhstan, Uzbekistan, Kyrgyzstan, and Tajikistan) and four observers (Pakistan, India, Iran, and Mongolia) together account for approximately one-fourth of the world’s land mass and population. The club also includes the world’s second and third highest military spenders. 4 Evan A. Feigenbaum, “The Shanghai Cooperation Organization and the Future of Central Asia,” speech at the Nixon Center, September 6 2007.

The Shanghai Cooperation Organization: A Threat to American Interests in Central Asia?


21

SCO states mitigate any energy-related concerns, with China seeking diversification from suppliers, Russia monopoly on production and transport, and the Central Asian states independence. While Iran’s entry into the grouping would provide Tehran an added measure of influence, the SCO has thus far shied away from conducting any serious discussions about promoting observer states to full membership. Most importantly, SCO nations may have exhibited similar behavior even in the absence of the formal multilateral forum; to validate western anxiety, the SCO’s organizational mechanisms must provide value-add for challenging American interests. With the apparently rising, Chinese-led, and Russian-supported organization attracting increased attention in Washington, the question becomes, which view of the SCO is correct? Is it a threat to U.S. interests in the region or largely irrelevant to those interests? To what extent does the nascent SCO currently pose a challenge, and secondly, what developments should the policy community track to assess the SCO as it relates to U.S. objectives for the region? In this article, I answer the above questions and in doing so develop recommendations for effective monitoring of SCO activity in Central Asia. Following a brief literature review, I identify three primary U.S. interests in Central Asia and assess the level of threat the SCO poses to each of them. I highlight which types of activities could occur just as easily outside the auspices of the SCO and which require such a multilateral arrangement. The concluding section includes an overall assessment and a note on several implications for U.S. policy towards the SCO and the region more broadly.

Literature Review and Contemporary Thought

Current western thinking on the Shanghai Cooperation Organization consists of three schools of thought. The first portrays a pessimistic outlook regarding the SCO’s future and its implications on U.S. interests in Central Asia. A leading advocate of this line of thinking is Stephen Blank of the U.S. Army War College in Carlisle, Pennsylvania. He believes that the SCO’s utility to Russia and China goes far beyond military exercises, stating in the Russian journal Demokratizatsiya: “Moscow and Beijing have clearly envisioned it since its inception as a forum for unifying the Central Asian governments in an anti-American regional security organization.”5

Although authors belonging to this school of thought do not usually mention concrete initiatives that the SCO undertakes (aside from rhetoric and declarations) against U.S. interests in the region, they

5 Stephen Blank, “U.S. Interest in Central Asia and Their Challenges,” Demokratizatsiya, (April 2007), p 318.

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speculate that Russia and China use summitry and other multilateral venues as a mechanism to pressure the smaller states into anti-American positions. Julia Nanay of the PFC Energy consultancy, writing online for The National Interest, goes as far as to say that Russia and China could “develop a Eurasian military grouping through the auspices of the SCO as a counterweight to NATO.”6 The second school of thought states that the SCO does not pose a threat at all. Some observers point to a long-term divergence of interests on the part of Russia and China, while others emphasize that a secretariat in Beijing and an annual meeting of heads of state is far from something to be concerned about. Martha Brill Olcott summarized this view in 2006 testimony to Congress, stating: “Today, I don’t believe that the Shanghai Cooperation Organization poses any direct threat to U.S. interests in Central Asia or in the region more generally…” and “I don’t have concern about the SCO.”7 Donald Rumsfeld even stated that the SCO’s Peace Mission 2005 exercise, which involved 10,000 troops conducting an amphibious landing operation, posed no reason for alarm: “I mean, countries do that…We are obviously observing what takes place, but I didn't see anything in it that was threatening…”8 The third line of thinking proposes that more time needs to pass before interested observers can determine what the SCO will become. No leading proponent of this argument stands out, but analysts at the Advanced Research and Assessment Group of the Defense Academy of the United Kingdom – the only entity that has released detailed observations and analysis on the Peace Mission 2007 exercise – conclude, “Although the West at present does not have anything to fear from the SCO, its current endeavors in the security dimension might encourage the West at least to closely observe further activities of the SCO but possibly also to seek cooperation with this organization.”9 State Department officials agree on a wait-and-see approach and acknowledge, “We don’t fully understand what the Shanghai Cooperation Organization does.”10 Observers from each of the three camps follow one of several approaches: briefly mention the SCO in a broader discussion on Central

6 Julia Nanay, “Inside Track: SCO Gaining Importance,” The National Interest online, August 8 2007. 7 U.S. Congress, United States Commission on Security and Cooperation in Europe (Helsinki Commission), Hearing: “The Shanghai Cooperation Organization: Is it Undermining U.S. Interests in Central Asia?,” September 26 2006. 8 “Rumsfeld: China-Russia drill no threat,” China Daily, November 25 2005, (November 18 2007). 9 de Haas, “The ‘Peace Mission 2007’ Exercises”, p. 11. 10 Evan A. Feigenbaum, “The Shanghai Cooperation Organization and the Future of Central Asia,” speech at the Nixon Center.



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Asia; describe the SCO but largely not in the context of the range of U.S. interests; or discuss the SCO in the context of U.S. interests but do so with a broad brush. This article fills a void in the current debate by focusing on the SCO specifically as it relates to U.S. interests in Central Asia. The concept of interests is, of course, illusive. Even if experts and decision makers manage to agree on defining American interests in a given region, the interests shift as time progresses. Proliferation concerns dominated the U.S. Central Asia agenda in the early 1990s, energy issues rose in importance during the mid- to-late 1990s, while counterterrorism topped the list of concerns after the turn of the century. Interests can also compete with each other. The foremost example of conflicting American interests in Central Asia revolves around the issue of maintaining government-to-government cooperation now while encouraging authoritarian governments to reform for the sake of stability later. Regions that present neither vast opportunities (like Eastern Europe after the fall of the Soviet Union) nor concrete threats (like Iran or North Korea today) add to this definitional dilemma.11 Central Asia fails to fall into a clear category, requiring a constant reexamination of the national interest. With the above caveat in mind, it remains possible to group American interests in Central Asia into three broad categories: energy, Afghanistan, and stability.

Energy: SCO the Cartel?

The U.S. Interests

American energy interests in Central Asia are relatively clear cut: moderating global prices via continued extraction of oil and gas in the region, ensuring pipeline security, promoting U.S. and European energy security through diversified suppliers and export routes, and supporting U.S. private investment.12 Although dreams of the Caspian Sea becoming another Middle East have faded since a premature euphoria in the 1990s, the region does represent a significant source of hydrocarbon reserves (See Table 1). Any disruptions to installations or pipelines would cause prices to rise, while continued exploration and extraction acts as a tempering force. Multiple export routes with substantial transport capacity (not a reality today) would provide a measure of energy security for western states, alleviating the consequences of events such as Russia’s

11 Eugene Rumer, Dmitri Trenin, and Huasheng Zhao, Central Asia: Views from Washington, Moscow, and Beijing (New York: M.E. Sharpe Inc, 2007), p. 23. 12 Jim Nichol, “Central Asia: Regional Developments and Implications for U.S. Interests,” CRS Issue Brief for Congress, Updated December 14 2007, p 27.

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January 2006 temporary cutoff of gas to Ukraine.13 Lastly, profits by American energy companies conducting business in Central Asia provide economic benefits to U.S. citizens and greater control over the region’s resources. Table 1. Hydrocarbons in Central Asian SCO States and Turkmenistan Hydrocarbon Oil Natural Gas

Nation

Proven Reserves (billions of barrels)*

Production (1000 barrels/day)^

Exports (1000 barrels/day)*

Proven Reserves (trillion cubic feet)^

Production (billion cubic feet/day)^

Exports (billion cubic feet)*

Kazakhstan 9-40 1426 1114 105 2.3 268 Uzbekistan 0.3-0.59 125 None 66 5.4 406 Turkmenistan 0.55-1.7 163 None 100 6.0 1596 Sources: * U.S. Department of Energy, Energy Information Administration; ^ BP Statistical Review of World Energy, Jun. 2007

Potential Challenges to U.S. Interests

Although some talk of energy security and exploration existed prior to the 2006 SCO summit in Shanghai, it was at that time that Vladimir Putin proposed the creation of an SCO Energy Club and thus moved energy issues beyond occasional discussions at working group levels and into the political limelight.14 At the 2007 summit in Bishkek, energy security and energy cooperation reportedly served as a major focus of the gathering.15 But no substantive developments have yet come to fruition, with SCO gatherings essentially serving as a meeting place for limited bilateral discussions. Those commentators concerned with an aggressive SCO in the energy arena hence point to possible future developments.

In a 2006 background paper published by the Central Asia-Caucasus Institute at Johns Hopkins University, Stephen Blank contends, “The formation of a genuine energy club in the SCO might not be that far away” and that “certainly any such organization would constitute a rival to any American-organized plans…”16 Blank’s argument focuses on Russia’s ambition to further monopolize its hold on Central Asia’s natural gas industry and become “an OPEC for natural gas.” He bolsters

13 Ibid., p 28. The more oil and gas that flows via transport routes that bypass Russia, the less damage there is from any cut-offs directed by Moscow. 14 Artyom Matusov, “Energy Cooperation in the SCO: Club or Gathering?,” China and Eurasia Forum Quarterly, 5, 3 (2007), p. 84. 15 Niklas Swanström and Nicklas Norling, “Editors Note – the SCO and the Bishkek Summit,” China and Eurasia Forum Quarterly, 5, 3 (2007), prelude. 16 Stephen Blank, “The Shanghai Cooperation Organization as an Energy Club, Portents for the Future,” Central Asia-Caucuses Institute Analyst, October 4 2006, pp. 1-3. For a similar argument, see also Mathew Brummer, “The Shanghai Cooperation Organization and Iran: A Power-Full Union,” Journal of International Affairs, 60, 2 (Spring/Summer 2007), pp. 185-198.



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the case by introducing the possibility that Iran’s joining of such a club would lead to a cartel with the world’s first and second leading producers of natural gas. An alternate view, also expressed in a Johns Hopkins publication, brings up a key actor not addressed in Blank’s analysis: China. As an energy-starved nation, why would China allow the SCO to form a gas cartel only to see it set higher prices?17 This narrative asserts that the real product of SCO activity on the energy front is management of China’s increasing access to Central Asia and the prevention of tensions with Russia. The question here, therefore, is whether the SCO is a cartel-in-waiting or a facilitator of Chinese integration into the region. Even more pertinent to Washington is whether either of these trajectories would clash with U.S. energy interests in the region.

Assessment

If a cartel formed and successfully raised global gas rates, the American objectives of keeping prices down and diversifying gas routes would indeed suffer. But numerous obstacles make the idea of a Russian-led, Iranian-supported, and Chinese-tolerated cartel both far-fetched and not altogether relevant to U.S. interests.

Russia could use Gazprom’s influence (it controls much of Central Asia’s natural gas and the pipelines that carry it) to coerce its smaller energy-exporting Central Asian neighbors into joining such a cartel. But China, the SCO’s largest net-importer of hydrocarbons, constitutes a significant barrier to any Russian plans for a natural gas cartel, as Beijing has shown and will continue to show serious reservations about participating in such an arrangement. Energy relations between the two SCO giants already exhibit stress. The basic issue at hand revolves around the Chinese desire to tap into the Central Asian energy market and do so with pipelines avoiding Russian territory. Over the last year, for instance, tensions rose as a result of competition over Turkmenistan’s resources: each seeks to build a new pipeline to transfer gas through its own territory.18 The Defense Academy of the United Kingdom, a group that closely monitors the SCO, concluded, “There is quite likely to be a clash of energy interests between Russia and China in Central Asia, and this could cause problems for international cooperation both in and around the region.”19 Given current and historical friction between

17 Matusov, “Energy Cooperation in the SCO,” p. 97. For a similar argument, see also Henry Plater-Zyberk, “Who’s Afraid of the SCO?” Central Asian Series, Advanced Research and Assessment Group at the Defence Academy of the United Kingdom, March 2007, p. 10. 18 Matusov, “Energy Cooperation in the SCO,” pp. 92-93. 19 Vladimir Paramonov and Aleksey Strokov, “Structural Interdependence of Russia & Central Asia in the Oil and Gas Sectors,” Central Asian Series, Advanced Research and Assessment Group of the Defence Academy of the United Kingdom, September 2007, p 1.

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Beijing and Moscow, it seems implausible that they can cooperate on a formidable effort to create an organization the size and scope of OPEC.20 In addition to the tension lies a fundamental, diverging interest. Beijing’s strategy consists of lowering the price of hydrocarbons to satisfy its energy-thirsty economy; Russia’s revolves around keeping prices high to facilitate export revenues. Seeing that Iran, like Russia, has a vested interest in high energy prices, Beijing will resist the idea of an expansive Energy Club operating as a gas cartel. From the American standpoint, furthermore, Caspian oil plays a more critical role than natural gas.

American energy interests in Central Asia relate to both natural gas and oil, but mostly the latter. Although in theory the U.S. government and American firms would like to invest in Caspian natural gas, several problems persist that make this investment both less likely and less attractive than the petroleum option. Difficulties with natural gas pertain to the aforementioned Gazprom influence and limited transport capacity. Almost all gas exports from the region pass through Russia.21 Prospects for natural gas pipelines that flow westward (or to India or China) exist, but remain in exploratory stages. Oil pipelines, on the other hand, already transport a limited amount of Kazakh petroleum eastward to China, with plans to do so westward to Azerbaijan and Turkey. American strategy from the 1990s to the present has rested on constructing the Baku-Tbilisi-Ceyhan (BTC) oil pipeline.

BTC currently pumps Azeri oil from Baku to Ceyhan and onto European markets, but the West has staked the success of the pipeline on ensuring that it also transports Kazakh oil. The last factor making oil more attractive than natural gas, and more central to American interests, revolves around the relative business-friendly environment of Kazakhstan (oil and gas) as compared to the instability of Uzbekistan (gas only) and potential member Turkmenistan (gas only).22 Although increased stability in Uzbekistan and Turkmenistan could propel American firms to display more interest in these nations, recent events

20 Although Blank eschews discussion about China, he suggests that India and Pakistan would seek full SCO membership to attain more favorable rates for their natural gas imports. Stephen Blank, “The Shanghai Cooperation Organization as an Energy Club, Portents for the Future,” p. 2. If Russia and China settle their current differences, Beijing could potentially follow the same course and agree to a cartel as long as Moscow arranged lower fees for natural gas imports. But that would mean Moscow would have to provide a discount to a large portion of its Eurasian customers. 21 Turkmenistan transports 12 percent of its extracted gas to Iran. Paramonov and Strokov, “Structural Interdependence of Russia & Central Asia in the Oil and Gas Sectors,” p. 2. 22 According to World Bank’s “Doing Business in 2008” reports, Kazakhstan ranks as the 71st most favorable nation for doing business and 28th in terms of contract enforcement. Uzbekistan is 136th overall and 46th in contract enforcement. The report does not rate Turkmenistan and other highly closed or unstable nations. See (February 1 2008).



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such as the Andijon crisis and the death of Turkmenistan’s ruler indicate the trend remains unfavorable.23 Kazakhstan and its oil, therefore, constitute the most critical element of U.S. energy interests in the region. Indeed, an often-overlooked point in addressing regional energy issues, and one particularly important in assessing the SCO, is the disproportionate importance of Kazakhstan. In addition to having the most favorable business conditions in the region, this country is by far the most critical oil producer and exporter in the region, with 2006 production and proven oil reserves accounting for 1.7 percent and 3.3 percent of the world’s total, respectively.24 No other Central Asian nation possesses even one-tenth of one percent of proven global oil reserves. Hence, any SCO-engendered (or other) challenges to U.S energy interests in nations other than Kazakhstan merit only secondary consideration.

Can Russia and China persuade Kazakhstan to sign agreements that, in whatever form, go against American interests? This brings the discussion back to what the SCO could possibly do to complicate U.S. policy. Other than the improbable cartel arrangement, observers have pointed to a management role for Chinese integration into the region, or perhaps the establishment of some form of common market. Kazakhstan has followed an omni-directional foreign policy, keeping relations stable with all three of its major partners: Russia, China, and the West. Ariel Cohen of the Heritage Foundation, an analyst deeply worried about the SCO’s impact on U.S. interests, admits, “There is good news regarding the SCO. The U.S. is expanding ties with Kazakhstan, [the] major oil producer with the region’s most liberal economic policy. It is also the nation most open to the West in the region.”25 For the foreseeable future, the SCO does not merit anxiety as it relates to U.S. energy interests in Central Asia. The prospects of an energy gas cartel are slim and, regardless, U.S. interests relate more to oil than natural gas. Kazakhstan’s linchpin role and consistent record of business-savvy relations with all of its major partners point to an SCO that could potentially manage China’s integration into the region, but not at a significant expense to the United States. One caveat to this analysis is the potential role of the SCO in the event of severe instability in the region.

23 For more on the Uzbek government’s widely criticized crackdown on a group of alleged terrorists and the death of Turkmenistan’s leader, see Jim Nichol, “Central Asia: Regional Developments and Implications for U.S. Interests”, pp. 11, 16. 24 BP Statistical Review of World Energy, June 2007; and U.S. Department of Energy, Energy Information Administration, Kazakhstan Brief, updated October 2006. 25 Ariel Cohen, “U.S. Challenge at the Shanghai Summit,” Web Memo published by The Heritage Foundation, June 13 2006.

Gene Germanovich


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Afghanistan: SCO the Sheriff?

The U.S. Interests

Support for Operation Enduring Freedom represents the most immediate (yet at least semi-permanent) U.S. interest in Central Asia. Manas Air Base in Kyrgyzstan provides a staging area for U.S. and Coalition military activity in Afghanistan, a key element in the fight against the Taliban insurgency. The base serves as home to the 376th Expeditionary Air Wing, the lead refueling wing and premier mobility hub supporting operations in Afghanistan.26 Following the expulsion of U.S. troops from Uzbekistan’s Karshi-Khanabad Airbase (commonly referred to as “K2”) in 2005, Manas took on an added importance as the only major facility in Central Asia home to U.S. troops. Thus in 2006, the U.S. tolerated a substantial increase in the annual price for access.27 Constant visits by high-level U.S. officials further point to the base’s significance.28

In addition to Manas, the other SCO Central Asian states also provide a range of assistance. Kazakhstan has in the past offered basing rights in an emergency situation. Tajikistan hosts a small contingent of U.S. and Coalition forces, and provides a refueling facility nearby Dushanbe. All of the Central Asian states provide over-flight rights for humanitarian missions, and some for search and rescue and combat operations. Together, these smaller elements contribute to the U.S. interest of military access in support of Operation Enduring Freedom. The Taliban’s strength and Afghan government’s inability to control its own territory, combined with a consensus in American politics about the need to attain stability, point to at least a medium-term presence of American troops in Afghanistan. Given the broad agreement that defeating the Taliban and limiting al-Qaeda’s capabilities remain a core national security interest, military access to Central Asia serves as the most pressing U.S. priority in the region.

Potential Challenges to U.S. Interests

As Eugene Rumor articulates, from 2001 to 2005 U.S. influence in Central Asia rose while that of the SCO’s was in decline: “In the near term, the most prominent victim of the post-9/11 security order in Central Asia

26 376th Expeditionary Wing website: (November 11 2007). The wing's around-the-clock mission includes strategic airlift operations, aerial refueling, combat airlift and airdrop, as well as aero-medical evacuation support when needed. 27 Jim Nichol, “Central Asia: Regional Developments and Implications for U.S. Interests”, p. 23. 28 Head of Central Command Admiral William Fallon visited in November of 2007, Secretary of State Condoleezza Rice in October 2007, and Secretary of Defense Robert Gates in June of 2007.



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was the Shanghai Cooperation Organization (SCO), and, by extension, China.”29

Although a few cautious observers raised the issue of an aspiring and potentially threatening SCO, it was not until a July 5, 2005 declaration at a summit in Astana, Kazakhstan that western interest in the organization started to peak. The lengthy statement, signed by each of the SCO’s heads of states, included a subsection implicitly calling for the United States to set a timeline from withdrawing its military forces from the bases of SCO member states. Several weeks later, Uzbekistan formally requested all U.S. forces to leave the K2 facility. Kyrgyzstan shortly thereafter reportedly felt pressure from its fellow SCO states to shut down the U.S. operation at Manas.30 At this juncture, a debate ensued as to the extent of SCO involvement in limiting the American military presence in Central Asia.

Did the SCO’s public statement at Astana and purported private pressure on Uzbekistan serve as the primary factor leading to the forced departure of U.S. troops at K2? Can SCO pressure on Kyrgyzstan engender a similar situation with Manas? Some experts, while acknowledging additional variables, point precisely to the SCO as the main vehicle used to uproot the American military presence in the region. Others disagree, noting that a deterioration of U.S.-Uzbek relations served as the impetus for K2 and that Kyrgyzstan’s continued acceptance of American forces at Manas demonstrates the relative weakness of the SCO in seeking to eliminate U.S. forces from Central Asia.31 In other words, does the SCO play the role of an aspiring sheriff or a boisterous, but ultimately marginal, observer?

Assessment

Three explanations point to the SCO as only a marginal limitation on America’s regional military presence. The first two – the scope of SCO statements and actions on the issue and the stake that SCO member states themselves have in Afghanistan – indicate that the SCO will continue to lack the capability and collective will power to present U.S. Afghanistan planners with a serious problem. The third explanation – Russian and Chinese geostrategic priorities – currently supports a similar conclusion, but depends on trends and thus has potential to gain in

29 Rumer, Central Asia: Views from Washington, Moscow, and Beijing, p. 57. 30 Blank, “U.S. Interests in Central Asia and Their Challenges,” p. 317. The author does not state, and it is generally

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